Two value investors I admire, Bill Ackman (Trades, Portfolio) and Whitney Tilson (Trades, Portfolio), have recommended that to learn about value investing, investors should read Berkshire Hathaway’s (BRK.A, Financial)(BRK.B, Financial) annual letters to shareholders. This series focuses on the main points Warren Buffett (Trades, Portfolio) makes in these letters and my analysis of the lessons learned from them. In this discussion, we go over the 1983 letter.
Stock splits are a controversial topic. In theory, a stock split should make no difference to the value of a company. Some argue that lower stock prices create liquidity and allow more investors to buy a stock, which pushes up the value of the stock. The liquidity argument has been citied in many of the prominent stock splits in recent years, such as those at Apple (AAPL, Financial) or Tesla (TSLA, Financial). Buffett dedicates a whole section of the 1983 shareholder letter to addressing the question of why Berkshire does not split its stock.
Shareholder eugenics
Buffett notes the assumption behind stock splits is that it is a “pro-shareholder action” and that Berkshire disagrees with this notion.
"One of our goals is to have Berkshire Hathaway stock sell at a price rationally related to its intrinsic business value. (But note “rationally related”, not “identical”: if well-regarded companies are generally selling in the market at large discounts from value, Berkshire might well be priced similarly.) The key to a rational stock price is rational shareholders, both current and prospective.
If the holders of a company’s stock and/or the prospective buyers attracted to it are prone to make irrational or emotion-based decisions, some pretty silly stock prices are going to appear periodically. Manic-depressive personalities produce manic-depressive valuations. Such aberrations may help us in buying and selling the stocks of other companies. But we think it is in both your interest and ours to minimize their occurrence in the market for Berkshire."
Buffett goes on to say that it’s not easy to “obtain only high-quality shareholders” as anyone can buy any stock and it’s beyond Berkshire’s ability to screen its shareholder “club." On the other hand, what Berkshire can control is to maintain a level of consistent communication of its business and ownership philosophy and then “let self selection follow its course." Buffett implies that while anyone can buy anything, advertising, or in this case Berkshire with its signalling of its policies, can drive what kind of investor base follows and invests in Berkshire. In this way, Berkshire can “try to attract investors who will understand our operations, attitudes and expectations." Conversely, this policy should dissuade a more speculative type of investor.
"We want those who think of themselves as business owners and invest in companies with the intention of staying a long time. And, we want those who keep their eyes focused on business results, not market prices."
Buffett thinks that investors like this are few and far between, yet “probably over 95%” of Berkshire’s shareholders are long term shareholders. Also, Buffett notes in relation to other large, widely held public companies, “we are almost certainly the leader in the degree to which our shareholders think and act like owners."
Stock splits
Buffett warns that if Berkshire split its stock or took other action focusing on stock price rather than business value then Berkshire “would attract an entering class of buyers inferior to the exiting class of sellers." Any investor preferring 100 shares at $13 per share over one share at $1300 would likely be an investor who buys for non-value reasons and is therefore likely to sell for non-value reasons and this, Buffett predicts, would “accentuate erratic price swings unrelated to underlying business developments."
Berkshire doesn’t want shareholders with a short-term focus on stock prices and therefore tries to implement policies that attract “informed long-term investors focusing on business values." This reminds me of the saying “you get the shareholders you deserve,” which both Buffett and Ackman of Pershing Square Holdings Limited (LSE:PSH, Financial) have said in the past.
Although he doesn’t mention it, Buffett then says something that reminds me of the classic investment book "Where are the Customers' Yachts?" published in 1940 by Fred Schwed:
"One of the ironies of the stock market is the emphasis on activity. Brokers, using terms such as “marketability” and “liquidity," sing the praises of companies with high share turnover (those who cannot fill your pocket will confidently fill your ear). But investors should understand that what is good for the croupier is not good for the customer. A hyperactive stock market is the pickpocket of enterprise."
Essentially, the more trading activity, the more an investor’s “frictional” costs via commissions and bid-ask spreads in the market and “this activity does nothing for the earnings of the business." Buffett calls it a “rather expensive game of musical chairs” and a self-imposed tax. Buffett is saying something which, although it makes sense when you think about it, seems counterintuitive at first: more trading volume is “a curse for owners, not a blessing."
At the market level of course this makes sense, even if at an individual level we might think we want higher trading volume to ensure better liquidity on entry and exit of an investment, but we are part of the market, and any trading activity we do incurs a cost. Buffett is telling us to forget about market conditions and focus on the value of an investment. Trading is akin to “financial flip-flopping” and the fees that brokers and fund managers charge "may decide who eats the pie, but they don’t enlarge it."
Buffett then rubbishes the argument that says that such activities improve the rationality of the capital allocation process because “on balance, hyperactive equity markets subvert rational capital allocation and act as pie shrinkers."
In a nod to Adam Smith, Buffett says that casino-type markets “act as an invisible foot that trips up and slows down a forward-moving economy."
Conclusions
Buffett is imploring us to focus on value and not price, to focus on the long-term, and reminds us about the frictional costs of trading. All this reinforces his belief that stock splits are a gimmick, which is why Berkshire's Class A shares have not been split to this day.
